REIT Industry Outlook (Feb. 2011)

The U.S. Real Estate Investment Trust (REIT) industry continued its growth momentum in fiscal 2010 with sustained improvements in the economy, driven by a spurt in real estate fundamentals and an increased inflow of funds as institutional investors have allocated more capital to the industry.

The FTSE NAREIT Equity REIT Index reported total returned 27.96% for full year 2010 vs. a 16.91% and a 15.06% for the NASDAQ Composite and the S&P 500 Index, respectively. This marks a solid back-to-back fiscal performance for the industry, as the FTSE NAREIT Equity REIT Index reported total returns of 27.99% in 2009.

The continued robust fiscal results of the REIT industry were primarily due to its unique business model. During the crest-to-trough period of 2007 to 2009, REITs took on far less debt than private real estate investors, and sold at the peak when private equity investors continued to buy.

On the other hand, when the market plummeted, REITs began to acquire properties from highly leveraged investors at deeply discounted prices and swelled up its kitty with premium assets that generate higher returns.

Furthermore, REITs are comparatively better equipped to raise capital to pay off debt, making them an increasingly attractive investment proposition. Since late 2010, mergers and acquisitions have gained an impetus as publicly traded REITs have benefited from access to the public markets to fund the transactions.

Healthcare REITs had announced $11.25 billion worth of acquisitions in 2010, led by $6.1 billion purchase by HCP Inc. (HCP), the largest medical REIT in the U.S. HCP acquired ownership interests in 338 post-acute, skilled nursing and assisted living facilities from HCR ManorCare Inc., a leading privately owned provider of skilled nursing facilities.

Redefining the market dynamics, ProLogis (PLD), a leading global provider of distribution facilities, also merged with its rival AMB Property Corp. (AMB) in early 2011 in an all-stock deal, creating a behemoth of sorts in the industrial real estate sector. The combined entity would have a pro-forma equity market capitalization of approximately $14 billion and a total market capitalization of over $24 billion.

The merged company will be treated as an UPREIT – an innovative business structure that forms an umbrella partnership between property owners and REITs. According to a report published by Jones Lang LaSalle Incorporated (JLL), a leading full-service real estate firm, direct investment in global commercial real estate (CRE) is further expected to surge by 25% to 35% year-over-year to over $350 billion in 2011 – the highest levels ever recorded since 2008.

In a recent research report, Jones Lang predicted that hotel sales and acquisitions would increase to the tune of 25% in 2011 in the Americas with investors vying for premier assets. Jones Lang further anticipated that transaction volume would total approximately $13.0 billion in 2011 and envisioned the U.S. hotel market as one of the most active in the world.

The report cited that a healthy rebound in the U.S. business and leisure travel has attracted a wide array of investors in the hotel industry, including investors from the Middle East. Jones Lang expects REITs to be the dominant buyers in 2011, with private equity groups and institutional investors increasingly joining the party as leverage levels and borrowing terms pick up with improving market fundamentals.

Investors looking for high dividend yields also favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors as the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders.The dividend yield for the FTSE NAREIT All REIT Index at year-end 2010 was 4.2% compared to 3.3% for the 10-year U.S. Treasury Note. Healthcare REITs recorded an impressive 69% increase in dividend payouts in 2010 – the largest in the industry, as revealed by data from SNL Financial, a premier multi-sector-focused financial information and research firm.

According to data complied by Bloomberg, healthcare REITs are anticipated to produce the highest dividend payout in the industry in first quarter 2011 buoyed by better-than-expected year-over-year revenue growth with accretive results from over $11 billion acquisitions announced in 2010.

The standout performance in the REIT industry during 2010 was that of the apartment REITs (a total return of 47.04% as measured by the FTSE NAREIT Equity REIT Index), followed by lodging/resorts (42.77%), regional malls (34.64%), shopping-center REITs (30.78%), self-storage (29.29%), diversified REITs (23.75%), and healthcare REITs (19.20%). The relatively underperforming sectors were timber (4.31%), and mixed-use REITs (8.75%).

OPPORTUNITIES

With a continued decline in the single-family homeownership rate across the U.S. and gradual improvement in the overall economy, apartment REITs have performed strongly in fiscal 2010. We expect this sector to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not avail mortgage loans or are unwilling to buy a house at present.

In this environment, we remain bullish on AvalonBay Communities, Inc. (AVB), one of the best-positioned apartment REITs primarily focusing on developing multi-family apartment communities for higher-income clients in high barrier-to-entry regions of the U.S. AvalonBay has Class A assets located in premium markets, such as Washington DC, New York City, and San Francisco, where the spread between renting and owning is still high despite home price declines.

In addition, AvalonBay has a reasonably strong balance sheet with moderate near-term debt maturities and adequate liquidity. Consequently, the company can capitalize on potential acquisition opportunities due to distressed selling by owners and developers who cannot refinance their properties, which augurs well for its top-line growth.

Currently, we are also bullish on CB Richard Ellis Group Inc. (CBG), the world’s largest commercial real estate services firm (on the basis of 2010 revenues). CB Richard Ellis is the global market leader in commercial real estate brokerage and advisory services for property leasing and sales, forecasting, valuations, origination and servicing of commercial mortgage loans, as well as project and real estate investment management.

The company has a broad range of real estate product and services, and an extensive knowledge of domestic and international real estate markets that enables it to operate as a single-source provider of real estate solutions. In addition, CB Richard Ellis has a hard-to-replicate intellectual capital and technology resources that develop and deliver superior analytical, research and client service tools to its professionals that enable it to meet diverse client needs.

Another stock worth mentioning is HCP (HCP), the leading medical REIT in the U.S. with one of the largest and most diversified portfolios in the healthcare sector having exposure to nearly all types of facilities. The product diversity of the company allows it to capitalize on opportunities in different markets based on individual market dynamics, and provides a hard-to-replicate competitive advantage over its peers.

In addition, HCP does not run the health care business at its facilities. Rather, it has established business relationships with a number of experienced healthcare management companies or operators who lease these properties on a long-term basis – generally for 10 to 15 years. Healthcare is also relatively immune to the economic problems faced by office, retail and apartment companies and is the single largest industry in the US, based on Gross Domestic Product (GDP).

Consumers will continue to spend on healthcare while cutting out discretionary purchases. This insulates the company from short-term market swings, and provides a steady source of income.

WEAKNESSES

A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.

We are bearish on Plum Creek Timber Co. Inc. (PCL), an REIT owning and managing timberlands in the U.S. Plum Creek’s business is affected by cyclical nature of the forest products industry. In addition, prices for logs and manufactured wood products remain highly volatile.

As such, factors beyond the direct control of the company undermine its long-term growth potential. Plum Creek’s business is also subject to strict environment policies, which have generally become more stringent in recent years.

The company has to adhere to all the state laws and regulations and incur significant expenditures to minimize the adverse effect on the environment, failing which it could face severe penalties. This considerably affects the bottom-line growth of the company.

We would also avoid Cousins Properties Inc. (CUZ) an REIT that acquires, finances, develops, and leases office, retail and industrial properties throughout the U.S. Cousins Properties has a large development pipeline, which increases operational risks in the current credit-constrained market, exposing it to rising construction costs, entitlement delays and lease-up risk.

Furthermore, Cousins Properties generate a significant amount of revenue from its office portfolio. Office demand is highly correlated to job growth. If job losses continue across the country, operations in the company’s office portfolio will suffer, thereby affecting the top-line growth of the company.

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